School of International and Public AffairsColumbia UniversityMay 14, 2004

Connecting the Source:The Case for Private Investment in

Infrastructure

Jefferson Clarke (MPA, 2007)Adam Glatzer (MPA, 2007)Alexander Kasuya (MPA, 2007)

1

Daniel Kosinski (MPA, 2007)Table of Contents

1 Introduction............................................................................................22 Overview.................................................................................................4

2.1 Economies in transition.......................................................................................42.2 The Political Economy........................................................................................42.3 Funding................................................................................................................7

3 The Case for Infrastructure Investment............................................103.1 Literature Review..............................................................................................103.2 Data Sources and Methodology.........................................................................123.3 Dependent Variable...........................................................................................123.4 Independent Variables.......................................................................................143.5 Adjusting for Limited Data................................................................................153.6 Correction Strategies.........................................................................................153.7 Results................................................................................................................163.8 Process for Omitting Outliers............................................................................183.9 Discussion..........................................................................................................203.10 Future Directions...............................................................................................20

4 The Consequences of Limited Industry Diversity.............................224.1 The Natural Resource Curse..............................................................................22

4.1.1 Dutch Disease............................................................................................234.1.2 Increased Volatility....................................................................................254.1.3 Inefficient Specialization...........................................................................274.1.4 Rent-Seeking Behavior..............................................................................274.1.5 Conclusion.................................................................................................28

5 Case Studies..........................................................................................295.1 Case Study: Russian Trans-Siberian Pipeline....................................................29

5.1.1 Background................................................................................................295.1.2 Economics..................................................................................................315.1.3 Politics.......................................................................................................325.1.4 Conclusion.................................................................................................33

5.2 Case Study: Georgia- The South Caucasus Pipeline.........................................345.2.1 Complications............................................................................................365.2.2 Future of the Pipeline.................................................................................375.2.3 Conclusion.................................................................................................37

6 The Strategic Approach.......................................................................396.1.1 National Oil Funds.....................................................................................396.1.2 Regional cooperation.................................................................................40

7 Citations................................................................................................42

2

1 Introduction

In the 1960’s the Karmet Steel Works in Temiritau, Kazakhstan was the largest industry producer in the Soviet Union employing 70,000 people and running a majority of the town services, but after the break-up of the Soviet Union in 1991, the company could no longer rely on guaranteed orders from the government and output fell by 50 percent. The local economy fell apart, drugs became rampant, and AIDS increased dramatically1.

In 1995 the LNM Group, an international steel group owned by Lakshmi N. Mittal, bought the dying steel mill and revived it into the largest private employer in Kazakhstan with 56,000 workers. The mill, now named Ispat Karmet, runs a majority of the private enterprise in the region, largely to ensure a steady supply of intermediate inputs necessary for production in the steel mill2.

Ispat-Karmet exemplifies how private investment can promote economic development in the Commonwealth of Independent States (CIS). Increasing private-sector investment in physical infrastructure networks such as energy, transportation, and telecommunications allows for industrial diversification, which prevents economic and political structures from becoming overly reliant on large industry sectors and enhances productivity in small and medium sized enterprises.

This paper examines the impact of the private investment in infrastructure on the economic and political development in the Commonwealth of Independent States (CIS). It attempts to distinguish socially responsible infrastructure investments from investments that are motivated by politics and designed to benefit small but powerful interest groups. The abundance of oil and natural gas in the CIS region makes the latter problem particularly acute as infrastructure development is often aimed at simply producing oil and natural gas for export and not creating value along the supply chain. This paper neither asserts nor claims that resource extraction firms are behaving irresponsibly, indeed in many cases they are, it instead emphasizes the negative effects of a sovereign economy becoming overly dependent on the natural extraction industry and the positive effects that can occur from increased investments in infrastructure.

This report consists of five sections. The first, Section 2, takes a broad overview of infrastructure in the CIS and is broken down into three themes. The first theme is the economic story and the role infrastructure plays in reducing poverty, investment, and growth in the region. It explains how spatial demography has changed in the CIS, including urbanization, rural settings, and other factors, and how these factors impacted the demands set upon infrastructure. The second theme explores the political economy and its role in infrastructure development, specifically addressing who captures the benefits from infrastructure and who are the providers, the recipients, and the funding entities. The third theme observes the funding of infrastructure investments to determine the scale of the regions infrastructure needs and how to resource those needs. This latter theme looks at what group is paying for the infrastructure and who is funding its construction.

1 Lewis, Charles Paul.” How the East was Won. The Impact of Multinational Companies on Eastern Europe and the Former Soviet Union”. pg66-732 Lewis, Charles Paul. How the East was Won. The Impact of Multinational Companies on Eastern Europe and the Former Soviet Union”. pg66-73

3

The second section of the paper is an economic analysis of the relationship between infrastructure and economic development. Based on well-documented evidence linking a positive relation between GDP per capita and physical infrastructure such as telecommunication, energy infrastructure, and transportation, this analysis builds upon evidence showing how infrastructure creates inclusive development by diversifying the industry sector.

The third section of this report examines the consequences of little or no physical infrastructure. Countries with unsophisticated levels of infrastructure become reliant on a small set of industry sectors increasing their economic fragility. This is especially true for the CIS countries that are heavily reliant on energy production. A well documented phenomenon in development economics is the natural resource curse. As defined by the International Monetary Fund, the natural resource curse can be the result of four factors: loss of competitiveness in the non-resource traded sector, increased volatility in commodity prices for the particular resource, inefficient specialization, and rent-seeking behavior.3

Section four includes specific case studies in private infrastructure investment and their contribution, or lack thereof, to inclusive economic development. The case-studies are the: Baku-Tbilisi-Cheyan Pipeline, the South Caucasus Pipeline, and the Trans-Siberian oil pipeline.

The final section of the report examines the strategic approach to investing in infrastructure. It looks at ways that countries can alleviate the natural curse such as establishing National Funds, increasing cooperation through regional initiatives, and assuming different investment schemes.

3 Barnett, S., and R. Ossowski “Operational Aspects of Fiscal Policy in Oil-Producing Countries,”

4

2 Overview

1.1 Economies in TransitionAs a region, the Commonwealth of Independent States has been growing at a

breakneck pace. From 2000 to 2004, the GDP of the CIS countries grew at an average rate of 8.7 percent, a large portion of this increase due to consistent growth in industry value-added; not a small feat given the economic hardship the entire region went through during and after the 1998 Russian Crisis. Inflation for the entire region has decreased significantly during the same period, averaging 34.38 percent in 2000 and 10.94 percent in 2004. The significant decrease in inflation was largely due to Belarus combating their initial inflation rate of 185 percent in 2000 down to 21.83 percent in 2004. The Gross National Income per capita of the region increased for the region as well from 747 USD to 1,279 USD by 2004. Unfortunately, the high economic growth rate is not spread equally throughout the CIS countries. A large majority of the GNI per capita remains in the Russian Federation, Kazakhstan, and Belarus (see Table 1). If we exclude the three countries from the regional average, the GNI per capita is only 840 USD in 2004.

Additionally, CIA estimates of the percentage of the population living below the national poverty line varies considerably throughout the countries with Moldova having 80% of the population living below the poverty line compared to the Russian Federation and Kazakhstan at 17.8% and 19%, respectively. A major determination of poverty and inequality lies in the dedication to reforms that countries within the region have undertaken.

Table 1: Macroeconomic Overview: Commonwealth of Independent States, WDI and CIA2004 GDP Bil USD

GDP Growth Rate2000 - 2004

GNI per Capita2004, USD

% Pop Below Poverty Line

Armenia 3.55 10.55 112 43%Azerbaijan 8.52 10.79 950 49%Belarus 22.80 6.7 2120 27%Georgia 5.09 6.34 1040 54%Kazakhstan 40.70 10.36 2260 19%Kyrgyzstan 2.21 4.972 400 40%Moldova 2.59 5.912 710 80%Russia 582.00 6.866 3410 18%Tajikistan 2.08 9.68 280 60%Turkmenistan 6.17 18.55 1340 58%Ukraine 65.1 8.36 1260 29%Uzbekistan 12.0 4.78 460 28%

1.2 The Political EconomyThe political economy of infrastructure is determined by who reaps the rewards of

infrastructure and who withstands the burden of its costs. Successful infrastructure within a country requires a prospective government with the long-term vision to recognize that its benefits will accrue over time. Thus, with government intent on realizing short-term gains for electoral purposes, infrastructure investment is often neglected and overlooked. Additionally, CIS countries with significant resources in oil and natural gas have resisted the urgency to build sufficient infrastructure, and in some

5

cases prevented the necessary reforms in the public sector in order to diversify their economies and take advantage of the foreign investment to better the standard of living.

Within the CIS region, infrastructure development has generally moved at a slow pace since the fall of the Soviet Union. An inefficient public sector and deteriorating infrastructure represent a significant challenge for the region’s prosperity. The region as a whole has had difficulties privatizing the public industries. The decision to privatize is often problematic because of a history of government involvement in the economy. In Azerbaijan, deteriorating infrastructure is due in large part to the government’s reluctance to privatize public services. Georgia has also recognized problems with privatization as it has experienced difficulty trying to sell its largest public firms to private investors. The selling of large firms requires significant capital investments, which are often deterred by weak governance and corruption. In Kazakhstan, attempts at privatization has occurred in several phases. The initial steps towards privatization were in housing and medium-sized firms with more than 200 employees. The program of privatization was performed using a voucher system, based on the Czech Republic, in which private citizens were given vouchers representing a set value, which could be deposited into established investment privatization funds. Although there were 170 investment funds set up, about ¾ of the vouchers went into ¼ of the funds, providing a few fund managers with an extraordinary amount of wealth4. The final stage of privatization, designed to sell the largest factories – largely ferrous-metal manufacturing plants – was scheduled for 1995, but was subsequently postponed several times. The government, reluctant to let go of its mineral and petroleum wealth, in lieu of selling the physical capital of large factories sold management contracts. The process of privatization has been slow, only 62 of the 194 enterprises listed for privatization were actually offered for sale, largely because the asking price was too high5.

Weak political institutions have also resulted in the proliferation of large-scale shadow economies in the CIS countries. Official statistics in Georgia indicate that 30% of economic activity takes place in the shadow economy, where government regulation and rules are nonexistent.6 In reality, these official estimates are usually grossly underestimated and the effect of the shadow economy within the CIS region has had serious implications on tax revenue. Until strong government institutions are fully developed, significant potential tax revenues will continue to be unrecognized and lost. In Azerbaijan, although a new tax code was introduced in 2001, there has been a failure to implement tax laws due to a weak administration and corrupt practices.7 Moreover, ratios of revenue and expenditure to GDP are small, reflecting the government’s inability to raise tax revenues outside of the oil sector. A lack of meaningful tax reforms compromises economic development. The latter effect is exemplified in Russia where stifling taxes and overregulation has impeded the growth of small firms within the country.

A history of socially planned economies has also produced a tradition of government interference in the economy. In Kazakhstan, the government has initiated efforts to reduce the size of its bureaucracy, but still uses the national budget as a political tool to blunt unrest that has occurred in the neighboring Kyrgyz Republic. Russia has 4 Olcott, Martha Brill. Kazakhstan: Unfulfilled Promise pg 1375 Olcott, page 1406 “Country Profile: Georgia 2005.” Economist Intelligence Unit.7 “Country Profile: Azerbaijan 2005.” Economist Intelligence Unit.

6

witnessed triple digit inflation because of its political commitment to promote the heavy industries regardless of profitability. The Russian government faces a serious challenge to impose meaningful budgetary constraints on enterprises and to foster a competitive environment that rewards successful companies and requires unsuccessful and inefficient firms to restructure or shut down operations.

The Business Environment and Enterprise Performance Survey (BEEPS) was a joint creation between The World Bank and the European Bank for Reconstruction and Development (EBRD), which interviewed over 4000 firms in 22 transition economies in 1999-2000. In a 2002 paper based on results from the Survey, authors Hellman, Jones and Kauffman found that corruption reduced FDI inflows. The paper also determined that foreign firms exacerbated the problems of state capture and procurement kickbacks in weak governance settings. The authors concluded that attracting a broader, more diverse set of foreign firms was vital in combating state capture and corruption.8

Corruption, weak governance, and a lack of economic diversification within the CIS region is a serious impediment to foreign investment. A World Bank Investment Climate Survey in 2005 found that of foreign firms surveyed in Azerbaijan, Georgia, Russia, Tajikistan, and Ukraine, over 70% of respondents indicated that bribes were paid either before or during operations.9 The 1999 BEEPS report also found that administrative corruption – namely unofficial payments, such as bribes and kickbacks to public officials – was markedly greater in the CIS compared to the Central and Eastern European (CEE) states.

However, it should also be recognized that CIS governments are beginning to address the corruption issue. In 2005, BEEPS carried out an updated survey on the CIS region and found that the percentage of firms that felt corruption was a problem for doing business had decreased. The same survey also found access to financing as a problem for doing business had decreased. CIS governments are beginning to recognize the negative effect corruption has on foreign investment and many states have shown a concerted effort to combat these issues. In Georgia for example, the targeting of several high-profile businessmen on charges of corruption and tax evasion has had a positive effect on persuading large firms to begin paying taxes, thereby improving the business climate. States also have the ability and obligation to allow citizens to follow where money is being spent. The creation of oil funds in Azerbaijan and Kazakhstan has also helped provide fiscal transparency by diverting oil income above the budgeted oil price into an oil windfall fund.

An important aspect of the BEEPS survey is that it attempts to address the hurdles faced by small- and medium-sized enterprises. Some of the most important roadblocks of development in transition economies are increasing the ability of small- and medium-sized firms to operate in a competitive atmosphere.

1.3 FundingThe goal of the World Bank Energy Group is to improve access to clean, modern

and affordable energy services for the world’s poor and to achieve sustainability in the

8 Hellman, J., Jones, G., Kaufmann, D. “Far From Home: Do Foreign Investors Import Higher Standards of Governance in Transition Economies?” 9 “World Development Report 2005.” The World Bank Investment Climate Surveys

7

environmental, financial, and fiscal aspects of the energy sector.10 In fiscal year 2004, the World Bank approved $1.05 billion in loan grants and guarantees in addition to $340 million net commitments by the International Finance Corporation11. Much of this funding, however, has gone towards power generation facilities as opposed to dedicated infrastructure. During the 1990s, the World Bank’s infrastructure business shifted from focusing on tangible industrial assets to a model of comprehensive service delivery. The shift in strategy attempted to create a more balanced composition complementing investments with regulatory reforms and institutional capacity building. It reflected a growing consensus that the right policy environment and institutional capacity are crucial for ensuring sustainable infrastructure investments. As a result, World Bank infrastructure investment lending, especially in IBRD countries, declined by 50% between 1993 and 2002.12

Over the same period, growth in much of the developing world remained flat aside from the economies of East Asia. In recent years, the World Bank has gained renewed appreciation for “bricks and mortar” projects as opposed to less tangible assets. As a result, it plans to ramp up infrastructure investment in the coming years.13 We believe this is indeed the best prescription for promoting sustainable economic growth and our model attempts to validate this in practice based on the World Bank’s own data sources.

Because of the large-scale requirements of infrastructure investments, there are different strategies of financing between private and public interests that need to be addressed. The World Bank looks at three different sources of financing for infrastructure, the private sector, public government, and official lenders and donors14. Different strategies of financing are associated with different levels of risk and accountability.

10 World Bank “Sustainable Energy.”11 ibid12 http://siteresources.worldbank.org/INTTRM/Resources/InfrastructureActionPlan.pdf13 ibid14 Asia Development Bank,The International Bank of Reconstruction , World Bank(May 2005) . Connecting East Asia:A New Framework for Infrastructure

8

Figure 1: CIS Private Sector Investment in Infrastructure (US$ billions)

CIS Private Sector Investment in Infrastructure (US$ Billions)

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

The World Bank maintains: “There are vital macroeconomic questions: Is there too much public expenditure on infrastructure, thus jeopardizing fiscal stability. Or is there too little expenditure, thus endangering economic growth and poverty reduction? 15” The World Bank defines four different investment strategies, these strategies are concession, divestitures, Greenfield projects, and management and lease contracts. Table 2 shows specific investment amounts from 1990 to 2004 for each strategy.

The concession investment strategy is based on a private entity taking over the management of a state-owned enterprise for a given period, for which it will assume a certain significant investment risk. As indicated in the table investment using concession strategies totaled $441 million.

A Greenfield Project is a private entity or a public-private joint venture that will build and operate and build a new facility under the contract project period. Under this strategy it will be held in the private sector with the ability to return to the public sector at the end of the contract period. Depending on the type of Greenfield, the private investor will build, lease, own, operate, or transfer at its own risk. Table 2 indicates Greenfield investments totaled $16.484 billion, the largest out of any investment strategies.

Divestitures is a concept in which the private equity will buy a large stake in a state-owned enterprise through an asset sale, a public offering, or a mass privatization program. Divesture is the second largest investment amount with $12.577 billion.

Management and Lease Contracts is where a private entity takes over the management of a state-owned enterprise for a fixed period while ownership and investment decisions remain with the state. There are two subclasses of management and lease contracts with investment at $20 million.

15 East Asia Infrastructure, World Bank page 35

9

Table 2: Private investment in infrastructure, World Bank

Concession DivestitureGreenfield

Project

Management and Lease Contract

(US$_billions) (US$_billions) (US$_billions) (US$_billions)Azerbaijan 0.375 0.000 0.369 0.000Armenia 0.050 0.583 0.000 0.000Belarus 0.000 0.000 1.064 0.000Georgia 0.000 0.172 0.215 0.000Kazakhstan 0.000 0.172 0.215 0.000Kyrgyzstan 0.000 0.088 0.021 0.000Moldova 0.000 0.085 0.085 0.000Russia 0.000 11.065 11.400 0.020Tajikistan 0.016 0.000 0.010 0.000Turkmenistan 0.000 0.000 0.000 0.000Uzbekistan 0.000 0.000 0.696 0.000Ukraine 0.000 0.412 2.409 0.000Total 0.441 12.577 16.484 0.020

Greenfield Project are as we can see the highest number of private-sector ventures undertaken. These projects are creating new facilities, and managing projects privately and can be shared with the help of some publicly sponsor ventures. With the ability to lease from the government and manage these infrastructures fully, the private sector will have major control of the project with the ability to return it to the public sector. The public sector, in this case, would not have to burden their asset flow and have the ability to spend the government’s money on other resources or investments that would not otherwise have as much or any private sector investment. The risk of private investment will fully be given to the private sector until the contract has expired, and the risk will be handed over to the public sector or kept with the private sector if it is maintaining the project still. The private sector will also have the ability to use more efficient methods of investment and growth of infrastructure then might the public sector hindered by restrictions.

10

3 The Case for Infrastructure Investment

Different industries have different requirements of factor inputs in their production process. The production function of industries is usually dependent on a certain ratio of labor, capital, energy, and intermediate materials to produce their final goods and services. In an idealistic economy, the geographic location of an industry is dependent on two important criteria: the availability of highly productive inputs necessary for production and the ability for the industry to transport their final product to the consumer.

With the above in mind, does it become possible to predict the specific composition of industries located in a country based on its existing infrastructure? For example, do countries with a sophisticated physical infrastructure system foster a specific portfolio of manufacturing industries heavily sensitive to transportation and energy prices? To ascertain the answers to these questions, this section will use each country’s existing infrastructure, including electricity, transportation, and telecommunications to calculate the level of diversity in the existing manufacturing industries. This analysis will focus on energy dependent manufacturing industries, such as steel, glass, and food production that require significant amounts of electricity during their manufacturing processes compared to other industries, such as tobacco.

Our empirical evidence shows that countries with more sophisticated levels of telecommunication, energy, and transportation systems are associated with a smaller proportion of energy dependent industries. We believe this is because less developed economies get stuck because of a breakdown in factor coordination. Typically reliant on energy intensive industries, they lack the advanced infrastructure necessary to support a diverse and highly developed industrial composition. Developed countries, which in comparison typically do have sophisticated infrastructure systems, are less likely to have energy intensive industries as the majority component of their manufacturing as a whole. Because of the limited data availability for CIS countries, our empirical analysis was expanded to the global scale to look for trends that can be applied regionally.

1.4 Literature ReviewThe origins of analyzing the relations between industry sectors in an economy

began with the development of input-output analysis by Wassily Leontief, earning him the Nobel Prize in Economics in 1973. In his seminal work, Input-Output Economics (1966)16, Leontief traced the interactions of firms within economies as a function of the outputs of one production function becoming the inputs of another. He describes the process best in his prize lecture:

“The world economy, like the economy of a single country, can be visualized as a system of interdependent processes. Each process, be it the manufacture of steel, the education of youth or the running of a family household, generates certain outputs and absorbs a specific combination of inputs. Direct interdependence between two processes arises whenever the output of one becomes an input of the other: coal, the output of the coal mining industry, is an input of the electric power generating sector. The chemical industry uses coal not only directly as a raw material, but also indirectly in the form of electrical

16 Leontif, Wassily W. Input-Output Economics 2nd ed. New York: Oxford University Press. 1986

11

power. A network of such links constitutes a system of elements which depend upon each other directly, indirectly or both.”17

Input-output modeling is an effective analytical tool for tracing out the indirect ripple effects among economies and helped intimately trace the true factors of production for industries beyond the aggregate of land, labor, and capital as defined by Karl Marx. The model also helped re-evolve the debate around comparative advantage, or a country’s ability to produce goods more efficiently due to cheaper processes of production, into terms of technology. This is set apart from the Heckscher-Ohlin theory, which described trade between countries simply in terms of labor and capital. However, Leontief’s model could not show changes in factor productivity due to increased technology and economies of scale. Input-output modeling is still widely used today. The Bureau of Economic Analysis annually produces the Regional Input-Output Modeling System, RIMS II, which tracks the interactions and trade flows between 473 industry sectors in the United States18.

The most recent gains in relating infrastructure with industry composition and comparative advantage lay in economic geography and gravitation modeling. Based on the idea of Newton’s Laws of Gravitation, gravity models predict trade flows based on the economic sizes and distance between units; a concept first used in the early days of econometric modeling. Additionally, Jan Tinbergen, who received the first Nobel Prize in Economics with Ragnar Frisch in 1969, utilized this concept with their basic gravity model as early as 1962.19 In modern economic modeling, New Economic Geography theory advanced with a new paper put forth by Masahisa Fujita, Paul Krugman, and Anthony Venables, in “The Spatial Economy”.20 Using a gravity model, the paper theorized that urban centers, which previously confounded economic modeling due to high transaction costs developed through the increase in access to labor and resource inputs. In other words, urban centers are expensive to live and operate in; high congestion drives up capital and labor costs, but these elements outweigh the benefits gained from access to productive inputs. Spatial analysis creates the link between infrastructure and comparative advantage. Sophisticated infrastructure systems allow cheap access to factors of production. An efficient transportation system expands a geographic region’s ability to purchase labor and commodities that are more productive and suitable to their particular production function. The idea also translates into energy and telecommunication systems. Regions with a critical mass lend to cheaper production costs. The idea of critical mass, reinforced by Michael Porter’s theory of a competitive cluster, theorizes that geographic clusters of specific industries, such as the high technology in Silicon Valley affect competition by increasing productivity for the companies located in the cluster, driving innovation, and stimulating new businesses.21Another study performed for the Transportation Research Board through the joint efforts of three consulting firms, Regional Economic Models, Inc., Cambridge Systematics, and Economic Development Research Group, Inc., analyzed the economic effects of congestion and found in their

17 Nobel Lectures, Economics 1969-1980, Editor Assar Lindbeck,18 RIMS II. The Bureau of Economic Analysis. 19 Nobel Lectures, Economics 1969-1980, Editor Assar Lindbeck,20 Fujita, Masahisa; Krugman, Paul; Venables, Anthony. The Spatial Economy. MIT press, July 1999. 21 Porter, Michael. Clusters and the New Economies of Competition.

12

labor cost model that doubling the labor force size by improving a transportation system will on average lead to an increase of productivity for all businesses in the region by 6.5 percent.22 Many of these same theories and concepts hold true for energy infrastructure. According to the World Bank, energy services are vital for poverty reduction and the Millennium Development Goals (MDG’s).

1.5 Data Sources and MethodologyThe goal of our final model was to be able to predict the percentage of energy

dependent manufacturing industries in a country given its level of physical infrastructure. In developing our regression model, we sought to regress variables that best represent a diverse and sophisticated infrastructure framework against an index variable created to represent the proportion of energy intensive manufacturing industries over the entire manufacturing sector. Described in greater detail below, our independent variables consisted of electricity consumption per capita, electricity production, percentage of paved roads, and the number of mobile telephones per 1,000 people. The variables were intended to be proxies for the energy, transportation, and telecommunications infrastructure. We also initially included a variable for the percent of energy imports used in consumption, although this variable was later dropped after thorough investigation and provided a theoretical backing to omit four observations (see Process for Omitting Variables section).

Data for our analysis was obtained from two data sets: the 2003 World Development Indicators (WDI) provided by the World Bank and the 2005 edition of the Industrial Statistics Database (INDSTAT3) at the 3-digit level (Rev.2) provided by the United Nations Industrial Development Organization (UNIDO). Our dependent variables for physical infrastructure were taken from the WDI and our independent index variable was created using different output numbers from the INDSTAT3 dataset.

1.6 Dependent VariableINDSTAT3 Revision 2 database contains time series data for the period 1963 to

2003, for 180 countries, although data is not available for every country and year. The dataset is arranged using the 3-digit level of the International Standard Industrial Classification of All Economic Activities (ISIC), Revision 2, pertaining to the manufacturing sector, which comprises of 28 manufacturing categories, plus the manufacturing sector as a whole. Due to data availability, we focused solely on the industry output series. We would have preferred to use the value-added time series, although this would have severely affected the number of observations viable for our regression model. All fiscal data are converted into current U.S. dollars using the average period exchange rates as given in the International Financial Statistics (IFS). Data for OECD countries were obtained from the OECD and data from non-OECD was obtained from national statistics offices by UNIDO23.

22 Weisbrod, G; Vary, D; Treyz, G. Economic Implications of Congestion.23 User’s Guide, INDSTAT3 2005 ISIC Rev. 2. United Nations Industrial Development Organization

13

In constructing our dependant variable, we chose specific industries that are highly energy intensive and expressed them as a percentage of the manufacturing sector as a whole. For purposes of this analysis, energy intensive industries are manufacturing industries requiring a significant amount of energy in their production function. Compared to other industries, energy intensive firms are more sensitive to changes in energy prices. We selected 8 manufacturing industries out of 29 as energy intensive. They are: food product, textiles, wood product, paper, industrial chemicals, glass, iron and steel, and non-ferrous metals. In Table 4, industries in the dependent variable are indicated with an asterisk.

Our selection of energy industries was based on information provided by the Energy Information Agency (EIA), a data and research agency with in the Department of Energy. For our analysis we used the EIA listed seven and eight most energy intensive manufacturing sectors24. Our dependent variable was the summation of the output for each industries divided by the total output of the manufacturing industry.

Because of data availability, we used the industry sector output instead of value-added. While value-added is a better measure of economic activity, the number of observations in our study was cut by half.

1.7 Independent VariablesDue to availability, we were not able to use the 2006 WDI data. The 2003 WDI

dataset includes 575 time series indicators for 208 economies, although data availability is not constant over the 10-year time horizon of our project. The World Bank is not the primary data collection agency for most of the WDI, with exception to living standard surveys and debt. Each variable used by the WDI was obtained from various sources.

To capture energy infrastructure we used two variables, electricity production and electric power consumption. Energy generation, measured in kilowatt hours, is a necessary component to this equation because higher levels of electricity production are a

24 Energy Information Agency, Department of Energy

14

Table 3: ISIC listCode Industry Description300 Total manufacturing311 Food products*313 Beverages314 Tobacco321 Textiles*322 Wearing apparel, except footwear323 Leather products324 Footwear, except rubber or plastic331 Wood products, except furniture*332 Furniture, except metal341 Paper and products*342 Printing and publishing351 Industrial chemicals*352 Other chemicals353 Petroleum refineries354 Misc. petroleum and coal products355 Rubber products356 Plastic products361 Pottery, china, earthenware362 Glass and products369 Other non-metallic mineral products371 Iron and steel*372 Non-ferrous metals*381 Fabricated metal products382 Machinery, except electrical383 Machinery, electric384 Transport equipment385 Professional & scientific equipment390 Other manufactured products

measure of large scale infrastructure development and industries that are energy intensive would require a large amount of energy to be produced, theorizing a positive relationship between energy intensity and electricity production. The variable is measured at the terminals of all alternator sets in a station. In addition to hydropower, coal, oil, gas, and nuclear power generation, it covers generation by geothermal, solar, wind, and tide and wave energy, as well as that from combustible renewables and waste. Production includes the output of electricity plants that are designed to produce electricity only as well as that of combined hear and power plants. Data sources for this variable are obtained by the World Bank from the International Energy Agency, Energy Statistics and Balances of Non-OECD Countries, Energy Statistics of OECD Countries, and Energy Balances of OECD Countries25. The difference in scale and magnitude between the upper and lower bounds of the variable required us to perform a logarithmic transformation so as to measure it as a percentage increase on the dependant variable.

Electric power consumption, measured in kilowatt hours per capita, provides an efficiency measure that includes net electricity imports, which is not accounted for in electricity production. Electric power consumption measures the production of power plants and combined heat, less distribution losses. The data sources for this variable are the International Energy Agency, Energy Statistic and Balances of Non-OECD Countries and Energy Statistics of OECD Countries, and United Nations Energy Statistics Yearbook26. As in electricity production, we transformed the variable into a logarithmic function to measure it as a percentage change on the dependant variable.

Our variable representing telecommunications infrastructure is mobile phone use, measured in mobile phones per 1,000 people, refers to users of portable telephones subscribing to an automatic public mobile telephone service using cellular technology that provides access to the public switch telephone network, per 1,000 people. The sources for this variable were obtained from the International Telecommunication Union, World Telecommunication Development Report and database27. We were initially indecisive about the variable because mobile phones may be implemented because of the lack of dedicated infrastructure and are more prevalent in lesser developed countries. But, we found that in practice it is more common for mobile phone systems to be prevalent in industrialized nations as addendums to dedicated infrastructure. Additionally, mobile telephones act as a proxy for economic development, a well documented case when regressing GDP per capita across mobile phone use.

Initially we had also included a variable for land line phones, which we thought was an indicator of the density of the power grid since energy lines are often laid in tandem with phone lines, and we did not have a measure for power lines specifically. Understandably, we ran into problems of multicollinearity with the mobile phones variable since mobile phones often augment existing infrastructure capabilities in land line transmission. Since we deemed mobile phones significant to serve both purposes indicating a more sophisticated telecommunication infrastructure generally, we chose to omit the land lines from our final model.

To capture the effect of transportation infrastructure, we included paved roads, measured as a percentage of the total road system. As measured by the World Bank,

25 User’s Guide, World Development Indicators, 2003 CD-ROM. The World Bank26 User’s Guide, World Development Indicators, 2003 CD-ROM. The World Bank27 Ibid.

15

paved roads are those surfaced with crushed stone (macadam) and hydrocarbon binder or bituminized agents, with concrete, or with cobblestones, as percentage of all the country’s roads, measured in length. The data sources for this variable are obtained from International Road Federation, World Road Statistics, and Eurostat28. As a measure of development, advanced economies have large transportation infrastructure systems, serving a variety of industries. In this case, a logarithmic transformation was not necessary because the variable is already represented in percentage terms.

1.8 Adjusting for Limited DataInitially we intended to create the model using panel data, but that limited our

model to a total of 50 observations out of a potential 180. We were considered with largely with data between 1990 and 2000, but data for different countries was available in different years, making a panel analysis difficult. Running cross-sectional analysis for different years also yielded highly different regression models. A few specific years, 1990, 1995, 1998, and 1999 had the largest amounts of data, but not consistently among countries. To adjust for this issue we collapsed the variables over the 10 year period, between and including 1990 to 2000, into average value for all countries. We then applied the mean value of the variables to a cross-section analysis. Using this technique we increased our observations increased approximately 60% to 79 observations.

1.9 Correction StrategiesWe tested for heteroskedasticity using the Bruesch-Pagan test and running bivariate

regressions of the model residuals against each of the independent variables. The model failed the Bruesch-Pagan test at the 5% level, but passed it at the 10% level, indicating some amount of heteroskedasticity. Looking at the scatter plots of energy intensity against each of the independent variables indicates some heteroskedasticity for both electricity production and consumption, although it is difficult to tell. We adjusted for heteroskedasticity by using the robust standard errors.

We tested for multicollinearity initially by looking at the correlation between all variables. Again, electricity consumption per capita provided some evidence of multicollinearity with mobile phones and pave roads, however after running the variable across the other independent and the variance inflation factor did not provide evidence of strong multicollinearity inflating the variance. Also, the significance test scores for all variables passed at the 1% level.

1.10 ResultsThe final model contained 79

observations. This was largely due to the dependent variable with the fewest observations. As seen in Table 5, the average energy intensity indicates 45 percent of all manufacturing industries in

28 User’s Guide, World Development Indicators, 2003 CD-ROM. The World Bank

16

Table 4:Detailed summary statistics

Percentile Energy Intensity1% 0.228325% 0.371750% 0.447375% 0.513699% 0.7707

countries are heavily dependent on energy in their production process29. Important to note are countries below the 25 percentile, 37 percent of industries are energy intensive, include the USA, Spain, and Japan. Countries above the 75 percentile, 51% of industries are energy intensive, include Kazakhstan, Ukraine, and Pakistan. There is clearly a relation between economic development and increased industry diversity.

Table 6 summarizes the four independent variables used in the regression. Due to the functional form of the mobile phones, electricity production and electricity consumption per capita variables, is it difficult to infer meaning. Paved roads has a high standard deviation and variability across countries.

Table 5: Summary table

Variable Mean Std. Dev. Min MaxMobile phones 1.6885 2.0194 -2.7331 5.5683Roads, paved 48.0075 32.8349 0.8000 100.0125Electricity production 23.5286 1.9615 -1225.0470 28.8973Elec. consump/capita 7.0820 1.5922 17.5505 9.7616

Figures 2 through 5 show the bivariate relationships between each of the independent variables and the dependent variable. Each scatter plot indicates a negative relationship between different aspects of physical infrastructure and the diversification of energy intensive industries. It should be noted with caution electricity consumption per capita is regressed across energy intensity indicates a negative relationship, but is a positive relationship in the full regression model. This is most likely due to the effects of economic development being absorbed by mobile phones.

29 Although this number is useful in the regression model, it should be used with caution. Due to the nature of the model, the United States of America is given the same weight as Kazakhstan. 45% does not imply 45% of all manufacturing industries’ output are energy intensive.

17

Figure 3:Energy intensity across percent of total roads paved

.2.4

.6.8

0 20 40 60 80 100(mean) paverd

(mean) enintense Fitted values

Figure 4: Energy intensity across electricity production (kWh)

.2.4

.6.8

18 20 22 24 26 28(mean) lnelecprod

(mean) enintense Fitted values

Figure 5: Energy intensity across electricity consumption per capita (kWh per capita)

.2.4

.6.8

2 4 6 8 10(mean) lneleconcap

(mean) enintense Fitted values

Figure 2: Energy intensity across phone mobiles (per 1000 people

.2.4

.6.8

-2 0 2 4 6(mean) lnphonembl

(mean) enintense Fitted values

Shown in Table 7, our final model was highly significant to the 99 percent level across all variables with an adjusted R-squared of 48.43 percent. As opposed to what we had originally theorized, increases in sophisticated infrastructure such as mobile phones and paved roads is associated with a decrease in energy intensive industries as percentage of the manufacturing sector as a whole.

More specifically, a 1 percent increase in mobile phone is associated with a 4.6 percent decrease in energy intensive industries as a percentage of the manufacturing sector as a whole holding all other variables constant; and a 1 percent increase in paved roads is associated with a 0.01 percent decrease in energy intensive industries as a percentage of the manufacturing sector as a whole holding all other variables constant.We observed a negative coefficient on the variable for electricity production. According to our observation a 1% increase in electricity production is associated with a 2.2 percent decrease in energy intensive industries as a percentage of the manufacturing sector as a whole holding all other variables constant.

Unlike the electricity production variable, our electricity consumption per capita variable was positively correlated with the dependant variable as we initially expected. Our model predicted that a 1 percent increase in electricity consumption per capita is associated with a 6.2 percent increase in energy intensive industries as a percentage of the manufacturing sector as a whole holding all other variables constant.

18

Table 6: Final regression model

1.11 Process for Omitting OutliersIn our early regression runs we included an energy imports variable, measured as

energy use less production, both in equivalents. A negative value indicates that the country is a net exporter30. The theoretical intuition behind the variable was to include an energy indicator that was not represented by electricity production. We believed it to be important because many manufacturing industries in developing countries generate their own electricity through generators running on imported fuel. Running the regression, however, created results that were highly heteroskedastic. Running a bivariate regression showed four outliers in the negative direction strongly influencing the entire regression. A seen in Figure 6, the observations are Kuwait, Oman, Gabon, and Norway, countries with economies largely dependent on exporting oil and natural gas. Attempting to validate the variable, we omitted the four observations and reran the bivariate regression. Without the four observations, the variable became a poor indicator of energy intensity overall and was dropped from the equation.

30 User’s Guide, World Development Indicators, 2003 CD-ROM. The World Bank

19

Figure 6: Energy intensity across energy imports (percent of commercial use)

ALB

ARG

ARM

AUS

AUT

AZE

BGD

BGR

BHR

BOL

CAN

CHL

CHN

CMRCOL

CRI

CYP

DEU

DNK

ECU EGY

ESP

EST

ETH

FIN

FRAGAB GBR

GRC

GTM

HKG

HND

HRV

HUN

IDN IND

IRL

IRN

ISL

ISRITA

JOR

JPN

KAZ

KGZ

KOR

KWT

LKA

LTU

LVAMARMDA

MEX

MOZ

MYS

NAM

NGA

NOR

NPL

OMN

PAK

PANPER

PHL

POL

PRTQAT

ROM

RUS

SEN

SLV

SVK

SWETHA

TTOTUN

TURTZA

UKR

URY

USA

VEN VNMZAF

ZWE

0.2

.4.6

.8(m

ean

) e

nin

ten

se

-1500 -1000 -500 0(mean) enimp

Later on in our modeling process, we reran the entire model without the four observations. The total number of observations in our model drops from 83 to 79, but the explanatory power increases by 25 percent. Table 8 shows the original regression model with the four outliers included. Compared to the original regression, the four outliers decrease the r-squared to 32.9 percent and the adjusted r-squared drops to 29.46 percent. The large increase in explanatory power variable occurs even without the inclusion of the energy imports variable in either regression. The four variables have a commonality between them that significantly decreases the ability of the model to explain industry sector diversity through enhancements in infrastructure. Because of the strong commonality of the four observations and that we came across them through observation, our final model has those four observations omitted.

Table 7: Regression model with outliers

1.12 DiscussionThe results of our final model31 indicate there is a strong association with

infrastructure and the proportion of manufacturing industries that are heavily dependant on energy. Countries with advanced infrastructure development rely less on energy dependant industries and therefore have a diverse economy. We observed that as the level of development increases, the level of dependency on energy dependant industries also decreases.

We were also surprised with the result of our electricity production variable since we expected it to be positively correlated with the dependant variable i.e. as electricity production increases, the percentage of energy intensive industries as represented by the manufacturing sector as a whole should have also increased. We speculate that electricity production is a development indicator like mobile phones and percentage of roads paved. As a country’s ability to produce energy increases, its ability to move into more diverse industrial sectors also increases thereby having a negative effect on energy intensive industries as a percentage of the manufacturing sector as a whole.

31 With the four outliers omitted.

20

What started as an infrastructure analysis ended as a study of risk. We found that economies with highly developed infrastructure are less dependant on energy intensive industries and are therefore more diverse. Diversity decreases risk so therefore an economy with more advanced infrastructure is less susceptible to swings in the economy than a country with lesser developed infrastructure. Section 4 will analyze the negative consequences of countries heavily reliant on a few industry sectors.

1.13 Future DirectionsThere are several assumptions made in this analysis that may have affected the

regression model. First, the dependent variable was developed using industry sector output data, although value-added data would have been more representative of true manufacturing activity in an economy. As data for value-added becomes more available, future regressions should include value-added data instead.

Second, to perform a cross-sectional analysis across all countries, we had to assume that the production function of energy intensive industries was the same in all countries. This a large assumption as productivity and energy efficiency varies for similar industries across countries. A possible correction strategy would be to include a measure energy elasticity or productivity, by industry, by country. Additionally, a productivity parameter would be to show the true increase in competitive advantage that infrastructure to economies through enhanced total factor productivity.

Finally, the idea of the analysis was to judge whether it is possible to determine the composition of industry sectors within an economy due to its physical infrastructure. To this end we looked specifically at energy intensive industries in the manufacturing sector. It would be useful to see whether there is any relation between infrastructure and different types of industry dependence, for example, the prevalence of transportation dependent industries over the whole. Additionally, it would be useful to expand the analysis beyond manufacturing and include the service and agricultural sectors, especially for more developed economies which are more reliant on the professional and service sector.

We believe the most important concept to come out of the model is the negative relation between levels of infrastructure and industry diversity. An interesting analysis would be to take this a step further and analyze the relation on the economic development of a country, such as GDP per capita, with a variable such as energy intensity. Based on our regression model, we theorize a negative relation between GDP per capita and energy intensity. Countries more reliant on a specific industry sector may be economically more fragile.

21

4 The Consequences of Limited Industry Diversity

The previous section showed the relationship between investment in infrastructure and country’s ability to diversify their economy. This section takes the analysis a step further to show the negative consequences for a country if the economy does not diversify and is dependent on a few industry sectors. A limited number of industry sectors can be counterproductive for several reasons. First, it correlates the revenue streams for the government with the economic activity of that particular industry. Second, the government and industry become increasingly intertwined, either through national control of the industry or clientism in which the government bends to the whims of the industry. The first reason increases the volatility of the economy to one market price. The second prevents productivity increases. Several countries in the CIS face the problem of over reliance with the energy production industry creating the conditions for the natural resource curse.

The natural resource curse is an economic phenomenon in which countries endowed with a significant amount of natural resources – oil, natural gas, diamonds, etc. – experience economic and/or political decline with increases in their extraction. The International Monetary Fund states the curse can be the result of four factors: loss of competitiveness in the non-resource traded sector, increased volatility in commodity prices for the particular resource, inefficient specialization, and rent-seeking behavior.32

One of the founders of OPEC, Juan Pablo Perez Alfonso, said of oil in 1975, “I call petroleum the devil’s excrement. It brings trouble… Look at this locura – waste, corruption, consumption, our public services falling apart. And debt, debt we shall have for years.”33

1.14 The Natural Resource CurseFour countries in the CIS have large energy export industries making their

economies susceptible to the negative effects of the extraction industry: Azerbaijan, Kazakhstan, Russian Federation, and Turkmenistan. All other CIS countries have to import energy for local production. Table 7 indicates the amount of energy the country exports in relation to their economies34. Countries with large negative amounts, such as Turkmenistan, are highly susceptible to the natural resource curse. The oil sector in Azerbaijan is responsible for 2/3 of industrial production and 90% of the country’s exports.35 Data is difficult to obtain, from Turkmenistan, but the oil and natural gas industries account for about three-quarter of the countries export earnings and more one-half of GDP36. Russia’s economy is heavily dependent on oil and natural gas exports, making it vulnerable to fluctuations in world oil prices. However, it is also a large beneficiary in today’s environment of rising demand and higher prices. Typically, a $1 per barrel change in oil prices will result in a $1.4 billion change in Russian revenues in the same direction.37 The World Bank has suggested that Russia's oil and gas sector may

32 Berengaut, Julie “Republic of Kazakhstan: Selected Issues”33 Devils, Excrement. The Economist34 This is the same variable used in Section 3: Process for omitting outliers35 Ibid36 Economist International Unit, Turkmenistan37 Energy Information Administration. Russia Country Analysis Brief and Non-OPEC Fact Sheet.

22

have accounted for up to 25% of GDP in 2003 while employing less than 1% of the population.

Table 8: Energy imports (% of commercial use)1992 1994 1996 1998 2000 2002

Azerbaijan -8.84558 7.767829 -20.7267 -38.1746 -64.7151 -68.9794Kazakhstan -11.7322 -21.5953 -39.4929 -63.1889 -97.7197 -104.091Russian Federation -44.3823 -50.4313 -53.6447 -59.691 -57.4173 -67.4404Turkmenistan -331.519 -143.017 -169.687 -50.2945 -217.612 -245.519

High energy exporting countries are not the only countries susceptible to the natural resource curse in the CIS. Countries such as Georgia and Ukraine earn money on the transit of oil and natural gas through pipelines in their country. If the revenue stream from tariffs is a significant portion of the budget the economy can become susceptible to currency appreciation and volatile swings in energy prices.

1.14.1 Dutch Disease

The first possible cause of the natural resource curse occurs from a loss of competitiveness in the non-resource traded sector. This economic phenomenon is nicknamed the “Dutch Disease” after observing the economic decline in the Dutch economy soon after the discovery of natural gas in the North Sea in the 1950’s. A merchant marine economy, more than 50 percent of the GDP relied on exports.38 With the discovery of natural gas, foreign direct investment in the economy drove up demand for the national currency increasing the cost of other export commodities resulting in a decrease in economic competitiveness. Sachs and Warner (2001) took this debate a step further to the manufacturing sector. The empirical analysis in their study suggested that resource abundance could inhibit the growth of key sectors in the economy, such as the tradable manufacturing sector, that are the engines of mass employment and growth. Theoretically applied to Sach’s and Warner’s conclusion, Azerbaijan, Kazakhstan, Russian Federation, and Turkmenistan would all potentially be sensitive to the Dutch disease. Table 8 aggregates and compares four industry sectors in the economy: Agriculture, Manufacturing, Mining, Energy, and Construction39, and Services. The data, value-added as a percentage of GDP, shows a drop from 1992 to 2004 in the value add of the manufacturing sector as a percentage of GDP for Azerbaijan and a small increase for Kazakhstan. For Azerbaijan, the decrease in the manufacturing sector is transferred into the mining, energy, and construction, strong evidence of the Dtuch disease in the economy. The majority of other countries show traditional patterns of economic development by decreasing reliance on the agriculture and manufacturing sectors and increase value-add as a portion of GDP in the service industry. Kazakhstan does not appear to exhibit adverse affects from the Dutch disease. Looking at the annual growth rate in value-add for the manufacturing sector for Kazakhstan, as seen in Table 9, shows strong growth from 1999 to 2000 and steady annual growth until 2004. This is

38 Wheelan, Charles. page 22339 Mining, Energy, and Construction sector variable comprises of the mining, construction, electricity, water, and gas. Corresponds to the International Standard Industry Classification (ISIC) divisions 10 – 14 and 40 – 45. The variable was created for this study for purposes of isolating the resource extraction sector (mining) from the manufacturing sector.

23

largely due to the strong growth in the non-ferrous metals industry from foreign direct investment by firms such as Ispat Karmet.

Table 9: Value-added for major ISIC sectors (percent of GDP), World BankArmenia Azerbaijan Belarus Georgia Kazakhstan Kyrgyzstan

1992 2004 1992 2004 1992 2004 1992 2004 1992 2004 1992 2004Agriculture 31 23 29 12 24 11 53 18 27 8 39 37Manufacturing 33 23 24 9 41 32 18 19 9 15 34 14Min, En, Con 6 14 16 46 7 8 6 7 36 24 4 8Service 30 40 32 32 29 49 23 57 29 52 23 42

Moldova Russia Tajikistan Turkmenistan Uzbekistan Ukraine1992 2004 1992 2004 1992 2004 1992 2004 1992 2004 1992 2004

Agriculture 51 21 7 5 27 24 11 n/a 20 12 35 31Manufacturing n/a 17 n/a n/a 34 22 n/a n/a 44 23 n/a 10Min, En, Con n/a 7 n/a n/a 12 8 n/a n/a 7 13 n/a 15Service 18 55 50 60 27 45 78 n/a 29 51 29 44

Table 10: Manufacturing, value-added (annual % growth) for Kazakhstan, World BankYear 1996 1997 1998 1999 2000 2001 2002 2003 2004Agriculture 0.3 4.1 -2.3 2.0 14.0 13.7 7.6 7.9 8.9

24

1.14.2 Increased Volatility

Revenue from natural resources may be more volatile than revenue from a broad base of export goods40. The IMF paper sites a study performed by Barnett and Ossowski in 2002 that volatile swings in resource revenues often lead to procyclical expenditures that may increase uncertainty and reduce investment and growth. Bartsch developed the idea further in 2004 by comparing public expenditure in selected countries to oil price fluctuations. For example, the study noted a strong positive correlation between the drop in public expenditure, measured in percent of GDP, and the drop in the world oil price for Venezuela and Nigeria. Additionally, the paper noted a small correlation between public expenditure and oil price fluctuations for Indonesia. The paper theorized the spending programs are often launched during periods of high resource prices or on the basis of expected future earning, without regard for the risks or costs associated with having to reverse them. If these spending programs become entrenched and the price of the resource falls, governments may have to borrow at a high cost without prudent regard for sustainability.41

Applying the same methodology to the Commonwealth of Independent States, this analysis compares government final consumption42 as a percentage of GDP with average annual world spot price of crude oil shows43. Figure 6 compares annual crude oil prices with government final consumption for energy importing countries in the CIS. There does not seem to be a strong affect from price fluctuations oil with exception for Moldova and Ukraine. Moldova has very little natural resources, its strong correlation with oil prices is the possible results of strong dependence of the economy with Russia. Ukraine’s tandem movement is not surprising due the large amount of revenue it receives in transportation tariffs is receives from natural gas shipped through pipelines from Russia to the European market. There does not seem to be any relation for Armenia, Belarus, Georgia, Kyrgyzstan, Tajikistan, and Uzbekistan. Figure 7 compares the same variables, but for energy exporting countries. Initially, Azerbaijan, Kazakhstan, and Russia exhibit similar patterns of spending movements in relation to the oil price, but start to level off in 2000. Notably, this is the when Kazakhstan and Azerbaijan establish their national oil funds.

40 Berengaut, Julie “Republic of Kazakhstan: Selected Issues”41 Ibid42As defined by the World Bank, General government final consumption expenditure (% of GDP) includes all government current expenditures for purchases of goods and services (including compensation of employees). It also includes most expenditures on national defense and security, but excludes government military expenditures that are not a part of government capital formation. All figures for this variable are taken from the 2005 World Development Indicators43 All figures for this variable are taken from the Energy Information Agency, historical prices.

25

Figure 7: Average annual spot price for crude oil (US$/bbl), EIA, compared to government final consumption (% of GDP), WDI, for energy importing countries

0

5

10

15

20

25

30

35

40

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Ann Oil Price

ARM

BLR

GEO

KGZ

MDA

TJK

UKR

UZB

Figure 8: Average annual spot price for crude oil (US$/bbl), EIA, compared to government final consumption (% of GDP), WDI, for energy importing countries

0

5

10

15

20

25

30

35

40

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Ann Oil Price

AZE

KAZ

RUS

TKM

26

1.14.3 Inefficient Specialization

Inefficient specialization of production with weak financial markets may lead to higher volatility in relative prices (Hausmann and Rigobon 2002)44. Hausmann and Rigobon study also theorized that a country highly dependent on a natural resource extraction industry would be sensitive to exchange rate fluctuations, although due to a relatively poor domestic financial system. With the over specialization of on particular industry, such as the oil industry, the financial system become over burdened with high bankruptcy costs driving up the local interest rate, again undermining the non-resource tradable sector.

This analysis will use similar conclusions found in the Dutch disease section, the strong growth of the ferrous manufacturing industry does not provide strong evidence of inefficient specialization as a factor of the natural resource curse.

1.14.4 Rent-Seeking Behavior

Rent-seeking behavior in reference to the natural resource curse is the link between the increase of corruption, weak government institutions, and poor economic policies, and even armament with windfall oil revenues. Easterly (2001) found that a vast common pool of resource accruing directly to the state will encourage misappropriation by interest groups and may undermine the governments commitment to transparency or accountability.45

Rent-seeking behavior is a serious issue in the CIS. In all four energy exporting countries of the CIS, the oil and natural gas industries are owned by the state providing a substantial revenue stream in the hands of the political elite. For Kazakhstan and Turkmenistan, much of the economic an political power has been provided to specific ethnic groups. In Kazakhstan, much of the power has been placed with the Kazakhs causing a large migration of the ethnic Russians to emigrate out of the country. Before the breakup of the Soviet Union, the ethnic split between the two groups we pretty even in terms of numbers – Kazakhs accounted for 40 percent of the population and Russian 37 percent46, although not in terms of power. Currently the ethnic divide country has shifted strongly in favor of the Kazakh population: 53.4 percent Kazakh and 30 percent Russian47. In Turkmenistan, recent estimates put ethnic Turkmen at 85 percent of the population48, up from 72 percent Turkmen in 198949. Much of the emigration in both states – due to corruption and discrimination – potentially decrease the local economy to cooperate and appreciate the benefits of increased productivity through economies of scale.

Another rent-seeking effect common in the CIS was the establishment of oligarchs through during the privatization process. Much of the valuable assets in the energy industry was provided to small elite. In Kazakhstan, the privatization process, or lack-of for the energy industry, combined with oil windfalls allowed the development of corruption and collusion between the government and energy industry. The domestic oil and natural-gas production industry still remains in state control through one company,

44 Berengaut, Julie “Republic of Kazakhstan: Selected Issues”45 Berengaut, Julie “Republic of Kazakhstan: Selected Issues”46 Olcott, page 1147 CIA World Factbook, Kazakhstan. 48 CIA World Factbook, Turkmenistan 49 Economist Intelligence Unit, Turkmenistan

27

KazMunaiGaz, also called Kazakhoil, remains is run by Nazarbayev’s nephew. Oil and gas transportation remain solely in the hands of KazTransGaz, heavily influenced by Nazarbayev’s son-in-law, the vice-president of the firm.

1.14.5 Conclusion

Looking at the four factors of the natural resource curse, the CIS, and especially Azerbaijan, Kazakhstan, Turkmenistan, and Russia are largely susceptible to its negative consequences. Unfortunately, all four countries show increased signs of rent-seeking and corruption that provides large benefits to a small interest group, either ethnic or economic.

If the resource curse then countries can help prevent the Dutch disease through increased investments in physical infrastructure. Investing in infrastructure increases the competitive advantage of the economy as a whole. Kazakhstan and Azerbaijan have been making strides to prevent the economic consequences from the Dutch Disease by establishing the National Oil Funds. Discussed more in Section 6, revenues in National Oil Funds can be specifically set aside to invest in infrastructure.

28

5 Case Studies

1.15 Case Study: Russian Trans-Siberian PipelineOil pipelines have many purposes, only one of which is to transport oil. In Russia’s

Far East, the actors constructing a trans-Siberian oil pipeline from the fields in Angarsk to the Pacific Ocean port of Nakhodka know this fact well. The Russian, Chinese, and Japanese governments as well as the Chinese National Petroleum Corporation (CNPC) and Transneft all have interests in seeing oil flow across the continent by means of pipe, yet their interests differ greatly and are only somewhat related to business and economics. What should be a matter of cost feasibility based upon market needs is instead mostly a political issue being exploited by competing interests in a rapidly changing region of the world. The Siberian Pacific Ocean Pipeline is not and perhaps has never been economic, but its impending construction proves that insecurity and offsetting power balances exist with great relevance in East Asia.

1.15.1 Background

Early versions of the Siberian pipeline project were far less ambitions than they are today. In 1994, China and Russia began cooperation on feasibility studies to examine the viability of an oil pipeline from the fields in Angarsk to China’s Daqing province to feed industrial centers within China. The original actors charged with carrying out that work were Yukos, the now bankrupt Russian oil major headed by the now imprisoned Mikhail Khodorkovsky, and CNPC50. The feasibility study was a complex technical undertaking due to the remoteness of the region and the lack of existing resources from which to conduct the study. Yukos and CNPC labored over the work for close to a decade.

During this phase, progress was being made on the political front to facilitate details of the deal. In 1999, Prime Ministers Yevgenii Primakov and Zhu Rongyi signed a framework agreement to investigate the export of oil and gas from Russia’s Far East signaling an improvement in bilateral relations and a proposed commitment of the natural resource.

Suddenly the climate started to change. Undoubtedly due to the events on and surrounding September 11th, nations around the world began to seek means by which they could diversify their dependence on Middle East oil. In 2002 Japan began buying Russian oil as a strategy to meet this end – a resource that had been forgone since 1978. Having ample supply, Russia was and is seen as a resource of strong significance for Japan’s energy strategy.

Simultaneously, the relationship between the Kremlin and Yukos began to deteriorate and so did the Yukos-CNPC deal. On May 28, 2003 Russian President Vladimir Putin declined to attend a signing ceremony between Yukos and CNPC to consummate the development of the Angarsk to Daqing pipeline at which Yukos and CNPC signed agreements committing CNPC to purchase up to 5.13 Billion barrels of Russian oil between 2005-203051. The signal was clearly taken in Beijing: warm relations had suddenly turned cold.

50 Shue, Stephen “The Chinese Perspective on the Daqing Pipeline Project.”51 Daly, John C.K. “China and Japan Race for Russian Crude.”

29

Behind the scenes, the Japanese government had been aggressively lobbying the Russian government to consider a pipeline not from the proposed Angarsk to Daqing, which would terminate deep within China, but rather from Angarsk to the Pacific port of Nakhodka, where it could theoretically serve the entire Pacific basin while remaining entirely within Russia’s territorial realm. As part of the enticement, the Japanese government offered to finance a large portion of the project in addition to allocating monies for exploration and social projects52.

The deal seemed to be sealed when Russian officials announced that the pipeline would run from Angarsk to Nakhodka as laid out in the Japanese plan over New Year’s Celebrations in 200453. Much to analysts’ dismay, however, the plan took yet another turn with the recent announcement by the Minister of Industry and Energy of Russia at the 2006 G8 Summit that a spur would be built off the Angarsk-Nakhodka pipeline running into China and terminating in Beijing making the proposed pipeline one of the largest most expensive ever built.

1.15.2 Economics

The East Asia oil market is extremely enticing. Economic growth in the region will cause the number of people living on $2 a day to fall from more than a billion in 1990 to a projected 340 million by the year 201554. This increase in wealth will beget large increases in energy consumption especially in the transportation sector.

Currently, China is the world’s second largest oil importer behind the United States equating to 6.5 million bbl/d. Chinese demand is expected to skyrocket over the next two decades, which according to the U.S. Department of Energy’s 2006 forecasts, is projected to be 14.2 Million bbl/d with net imports of 10.9 million bbl/d by 202555.

For Yukos and CNPC, these forecasts proved reasonable enough to gamble big. The originally planned Angarsk-Daqing pipeline was estimated to cost $2.8 Billion adding considerable transportation costs to unproven reserves56. Given this estimate of

52 Rutland, Peter “Pipeline Pirouette in Northeast Asia.”53 Blagov, Sergei. “Russia Walks Thin Line Between Japan and China.” 54 Editors. “Seven Futures.” CSIS.55 Editors. “Major Russian Oil and Natural Gas Projects.”56 Jamestown, ibid.

30

capital expenditures and the pipeline’s proposed output of 0.6 bbl/d, Yukos and CNPC could expect to pay a $1.01 per barrel premium under normal financing conditions. If, however, concessionary financing arrangements were arranged, that cost could be roughly lowered to $.69 per barrel depending on the arrangements of the loan. Such oil would have to compete directly with crude imported from the Persian Gulf.

As a region, Asia has the fastest growing oil demand in the world equating to annual increases of 3%-4%. Japan closely rivals China as the world’s 4 th largest oil importer at 5.35 million bbl/d57. An estimated 75%-80% of Japanese oil comes directly from the Persian Gulf – a condition that politicos in Tokyo would like to see undone.

The Russian government sees great potential in the Asian oil market. According to recent statements by the Russian Minister of Industry and Energy, the government expects the Asian portion of Russian oil exports to rise from today’s levels of 3% to 30% by the year 2020 equating to an upper bound projection of 2 million bbl/d. The Angarsk-Nakhodka plan was designed to capitalize on this growing demand.

Cost estimates for the Angarsk-Nakhodka pipeline are extremely murky. Originally, the cost was projected at roughly $9 Billion of which the Japanese had pledged $7 Billion with upstream exploration and social development costs included, but more recent estimates project the cost to be between $15 and $18 Billion. Furthermore, the Russian government has committed to building a spur from Skovorodino that does not appear to be included.

The end capacity of the pipeline is expected to be 1.6 million bbl/d of which 0.6 million bbl/d are slated for China58. Roughly speaking, assuming capital expenditures of $16.5 Billion for 2,500 miles of pipeline and an additional 30 miles from Skovorodino to the Chinese boarder at $198 Million, net back expenditures could be $6.29 per barrel for the entire output of 1.6 million bbl/d. Concessionary financing arrangements might lower this to around $4.29 per barrel depending on the arrangements of the loan. These estimates do not account for varying expenditures based upon delivery location and output, which are both important factors in determining the final net back costs. One fact is clear, The Angarsk-Nakhodka pipeline with the Skovorodino spur will be the most expensive pipeline in history.

1.15.3 Politics

While China is booming to the south, Russia is quite literally a dying nation. The Japanese National Institute for Research Advancement approximates the number of permanent residents in Russia’s Far East to be 7.2 million people and predicts a decrease to 6.8 million people by the year 201559. A declining Russian population means less inhabitants in an already sparsely populated region that is rich in natural resources held up by little infrastructure and economic opportunity. In historical perspective, the Cossacks began entering the Far East as late as the 16th century (which qualifies as recent history under the long chronicles of the region). Three centuries later, the trans-Siberian Railroad brought the first consolidation of Russian authority and with it access to the region’s natural riches. Today, the Russian government sees a trans-Siberian pipeline as a

57 Editors. “Japan-Oil.”58 DOE. “Major Russian Oil and Natural Gas Projects.”, ibid.59Editors. “NIRA Policy Research.”

31

means to build additional infrastructure, create job growth, and promote economic development60.

The Chinese are seemingly content within their geopolitical boundaries, but it is provocative to suggest that China could become enticed into an energy-rich region depleted of Russians and rapidly filling with ethnic Chinese if the opportunity presented itself peaceful or otherwise. Most likely, however, China will seek to improve its position relative to sourcing diversification while creating sufficient economic incentives for Russia to be involved. At what point those incentives prove to be too costly, remains to be seen. Under the recently proposed plan, China would contribute to an $18 Billion project that was originally $2.8 Billion. Financing arrangements, therefore, are largely unresolved as the Japanese have pledged less than half the cost of the main branch with nothing at all slated for the Skovorodino spur. Chinese pipeline deals underway with Kazakhstan indicate that they are willing to go elsewhere if Russo-Sino relations become too complicated and indeed they might.

Japan is concerned with sourcing diversification as is China, but even so constructing the largest most expensive pipeline in history seems like a heavy premium to achieve such ends. More likely, the threat of increased cooperation between Russia and China – Japan’s largest trade partner – and an unresolved territorial dispute over the Kuril Islands are also factoring into the cost benefit analysis. The Japanese financing concessions enable the Russians to build a favorable infrastructure project, restrict the Chinese from accessing Russian oil unfettered, and coax the normalization of Russo-Japanese relations.

1.15.4 Conclusion

According to a recent statement by the Ministry of Industry and Energy of Russia at the G8 Summit:

In the 21st century geopolitics is being replaced with geoeconomics, which gives priority to a nation’s ability to compete with others. Geoeconomics is determined by the market capacities and positions, flow of goods, capital, services and manpower, integration, and cooperation in the economy and other spheres61.

60 Khristenko, Viktor. “Breakthrough to the East.”61 Khristenko, ibid.

32

Such defines the battle being waged over the Siberian Pacific Ocean Pipeline. The manner in which the Minister refers to the decision making process itself is revealing:

The pattern has been determined, and will now be followed by designing and commercial calculations. Discussion of the first stage of construction (Taishet-Skovorodino section) has moved onto a corporate, pragmatic level – potential forms of participation of different companies, and risk diversification.62.

The Siberian Pacific Ocean Pipeline has not been designed under a competitive market and is not suited to serve competitive market. Pragmatism is a convenient way to organize the numbers rather than drive the decision making process. Therefore, economic motivations are not ends but means by which competing states in a rapidly changing region can exercise influence.

1.16 Case Study: Georgia The South Caucasus PipelineOn January 22, 2006 two explosions in Russia’s North Ossetia province shut down

the main pipeline exporting natural gas to Georgia. The explosions prompted Georgian President Mikhail Saakashvili to conclude that the accident was carried out by Russian forces in order to create a destabilizing energy crisis within his borders. Following the crisis, Saakashvili declared, “This is the last winter when it will be possible to launch an energy offensive against us... because a new gas pipeline [the South Caucasus Pipeline] will be launched in the fall [2006].”63 The President followed his remarks with an op-ed in The Washington Post on January 9, 2006 in which he urged the international community to seek alternatives to Russian energy supplies.

Regardless of who was behind the explosions, the accident raised concerns about the future security of Caspian oil and gas exports across the Caucasus. The Caucasus region is notorious for conflict and pipeline attacks have been widespread in the past. For Tbilisi, the gas disruption highlighted its complete dependence on Russia for its gas supplies. Russia has used this dependence to its advantage by bullying the State to meet its needs. In December 2005, a deal was reached in which Georgia agreed to pay $110/cubic meter (cm) for Russian gas- a nearly 200% price increase over its previous rate of $62.50/cm- yet still substantially lower than the European gas rates.64 Recently, the Russian gas monopoly, Gazprom, has insisted it will force Georgia to pay European rates unless Tbilisi increases its dependence by selling a trunk pipeline and its main gas distribution systems to Gazprom for $250 million.65

However, three factors have prevented Georgia from accepting this deal. First, the pipeline explosion illustrates Gazprom’s inherent unreliability; second, Georgia recently received the US Millennium Challenge Account Funds (which are partially earmarked for the rehabilitation of the trunk pipeline); and third, the South Caucasus Pipeline (SCP) will be providing natural gas to Georgia by September 2006.66 For Georgia, the SCP will have a monumental effect in reducing dependence on Russian gas, strengthening ties with the European Union (EU) and the United States, and providing much needed transit revenues in the form of natural gas.

62 Khristenko, ibid.63 Ismayilov, Rovshan. “Azerbaijan: An Unlikely Solution to Georgia’s Energy Woes.” 64 “Geopolitics.” Petroleum Economist65 “Georgia fears upcoming agreement could give Gazprom control.” Alexander’s Gas & Oil Connection66 Socor, Vladimir. “Georgia Extricating From Gazprom’s Bear Hug.”

33

The 690 km SCP will transport gas from the Shah Deniz field, one of the largest gas fields in the world, from Azerbaijan through Tbilisi to Erzurum, Turkey where it will connect with the Turkish gas grid. The field has proven gas reserves of 625Bcm (22.1 trillion cubic feet), and British Petroleum (BP), the technical operator overseeing the Shah Deniz project, is confident that recent assessments will result in a 25 percent increase in its proven reserves.67 The Shah Deniz project was cultivated from Turkey’s exaggerated gas demand projections in the 1990s, Georgia’s desire to divert its energy imports away from Russia, and Azerbaijan’s aspirations to connect to European markets. BP and Norway’s Statoil each hold a 25.5% stake in the Shah Deniz project; 10% stakes are held by Total, Azerbaijan’s State Oil Company (SOCAR) and the National Iranian Oil Company (NIOC); and a partnership of Russia’s Lukoil and Italy’s Agip hold 10% between them, while Turkish Petroleum maintains 9%.

At a cost of over $4bn, the South Caucasus Pipeline will ultimately have a 20Bcm/year capacity.68 The SCP, which will follow the same route as the Baku-Tbilisi-Ceyhan (BTC) oil pipeline to Turkey, will consist of a 42 inch pipeline, supported by a compressor station, as well as two sales gas off-takes in Turkey and Georgia. Because of Turkey’s diminished demand for the gas, it will buy approximately 2-3Bcm in 2006, 3-5Bcm in 2007, and 6.6Bcm/yr from 2008-2020.69 Georgia, meanwhile, will receive 5 percent of the transported gas as a transit fee in lieu of cash and will be able to purchase an additional 0.5Bcm per year at a cost of $55/cm.70 By the time the pipeline reaches its capacity toward the end of the decade, the SCP producers hope the route can be used as a transit to European markets where it can compete with Gazprom for market share. Georgian Implications

While the South Caucasus Pipeline will greatly affect all countries involved, Georgia will reap the largest rewards from the new gas route. At present, Georgia’s natural gas is received solely from Russia. Even natural gas imported from Turkmenistan is re-routed through Gazprom’s pipelines by Russia’s private company, Itera, which leads to higher transport costs. Under the previous President Eduard Shevardnadze, Tbilisi strengthened its energy ties to Russia with agreements signed in 2001-2002, in which Gazprom was awarded nearly complete control over the national pipeline network. The United States voiced its concern over Gazprom’s “extending monopoly” in the Caspian and advised the Georgian government to refrain from any steps which could affect the viability of the SCP and BTC.71 During this time, Russia also undertook efforts to undermine the feasibility of the SCP. On June 4, 2003 the Russian Deputy Prime Minister Viktor Kalyuzhny proposed that Azerbaijan should use a Gazprom-manned underwater route connecting Russia to the Turkish port of Samsun rather than rely on the SCP for its exports.72 Gazprom also announced plans to modernize a pipeline running through Georgia’s southern region of Ajara and extend it to Turkey. In the buildup to the 2005 Georgian presidential elections, the importance of ensuring gas supplies was vital to

67 “BP’s Shah Deniz Gas Marketing Puzzle.” World Gas Intelligence68 Ibid“We were fairly confident in sizing the pipeline at 20Bcm that there would be more gas,” stated David Woodward, President of BP Azerbaijan69 “South Caucasus Pipeline close to beating the odds.” 70 “BP’s Shah Deniz Gas Marketing Puzzle.” 71 “Georgia fears upcoming agreement could give Gazprom control.” 72 Ibid

34

President Shevardnadze, who responded by increasing his country’s dependence on Russia in exchange for uninterrupted gas supplies.

Yet with the SCP due to come online in September 2006, Caspian gas will be available for the first time in Georgia. Aside from reducing its energy dependence on Russia, the pipeline will benefit Tbilisi in several areas. During negotiations, Azerbaijan agreed to double Georgia’s transit fee at its own expense, which will lead to the latter receiving 5% of the gas transported through the pipelines as a payment-in-kind. It can then sell that gas if it chooses at a rate of $100/cm in the first year with this price rising by 2% each year. The state will also benefit from low gas prices to meet most of its additional demand. Georgia will be able to purchase an additional 0.5Bcm/yr at a fixed price of $55/Mcm, with this price increasing by 1.5% annually.73 With both the BTC and SCP routed through Georgia, the government expects to receive 1% of GDP, around $80 million, in additional revenues per year over the medium term (see Figure 9).74

1.16.1 Complications

However, while the South Caucasus Pipeline will benefit Georgia in many ways, the project also brings several complications. Georgia currently demands 1.34Bcm/yr in gas, yet it can only receive approximately 1.00Bcm/yr in the near to medium term. 75

73 “BP’s Shah Deniz Gas Marketing Puzzle.” World Gas Intelligence 74 Billmeier, Andreas, Jonathan Dunn, Bert van Selm. “In the Pipeline: Georgia’s Oil and Gas Transit Revenues.” 75 This is assuming the pipeline transports around 10Bcm/yr in the near to medium term (5-10 years). Georgia will receive 5% of this as a transit fee, which equals .05 x 10Bcm = 0.5Bcm. It also has the ability to purchase 0.5Bcm, this giving it a total of 1.0Bcm, which is less than its present demand of 1.34Bcm.Even under most optimistic assumptions in which the SCP has a capacity of 30Bcm, transit revenues to Georgia will only equal 1.5Bcm.

Figure 9: Georgia Oil and Gas Transit Revenues

35

Georgia is presently engaged in discussions with Azerbaijan over purchasing additional gas from the pipeline. The Georgian government is prepared to guarantee the payments and pay for the gas upon delivery, yet some Azerbaijani experts are skeptical Georgia will be able to make its payments. Compounding the problem, Georgian gas-fired power and fertilizer plants are owned by Russian companies and it is probable they will insist on acquiring Russian feedstock. Thus, it is unrealistic to assume that Russian gas will be completely removed from the Georgian market in the near future.

1.16.2 Future of the Pipeline

As commercial operator of the SCP, Statoil has begun assessing European markets as an alternative destination due to Turkey’s reduced demand for the gas. European gas demand is projected to increase substantially in the future- conservative estimates believe EU demand will double from 200Bcm in 2002 to 400Bcm by 2030.76 A gas pipeline between Turkey and Greece is expected in 2006 and will provide the first opportunity to send Caspian gas directly to European markets (see figure 3). This prospect has prompted Russia to try to prevent new entrants from entering the EU gas market. Russian gas exports to the EU comprise 25% of Gazprom’s total production and a whopping 75% of its revenues. Gazprom’s exports also account for 20-25% of Russia’s total export revenues, a significant amount which will likely decrease with the emergence of Caspian gas.77 As Georg Gundersen, President of Statoil Azerbaijan has stated in referring to the EU’s demand projections, “We want to have our share of that cake.”78 With Europe pursuing diversified energy supplies and the Caucasus interested in accessing these markets, there may be a good strategic, if not economic, match between the interests of Europe and the South Caucasus.

1.16.3 Conclusion

The SCP and BTC Pipelines will benefit Georgia both politically and economically. As one of the few CIS countries with limited resources, Georgia’s economic development is dependent on serving as an important transit state for the Caucasus region. The projects offer significant revenue potential and provide an opportunity for further foreign investment as long as the government provides an attractive setting for investors. Positive signs include the government’s commitment to structural reform, such as the simplification of obtaining licenses and permits to encourage private-sector activity. The reforms have resulted in renewed foreign loans and praise from the IMF in 2005 on the country’s reform process. Higher revenues from taxes, as well as rising privatization receipts are providing the government with the opportunity to increase public spending especially in infrastructure and the energy sector. Until Georgia achieves energy independence, the importing of oil and gas will continue to spark energy shortages, hamper economic activity, and produce unfavorable macroeconomic conditions. However, by serving as a transit state for the SCP, Georgia now has a direct stake in the supply and shipment of Caspian gas. The SCP significantly reduces its dependence on Russia for energy supplies, provides natural gas at favorable rates, and strengthens relations with the US. In recent years, Georgia has finally come to

76 Tsereteli, Mamuka. “Caspian Gas: Potential to Activate Europe in the South Caucasus.” 77 Ibid78 “With Shah Deniz gas two years off, quest to grow project in motion.” Platts Oilgram News

36

the realization that its greatest economic, political, and strategic benefits hinge on its ability to become an important transit state. The South Caucasus Pipeline illustrates that Georgia has emerged as a significant actor in the Caspian region, and one in which both European and American interests converge.

37

6 The Strategic Approach

There are several strategies governments in the CIS can use in combination to increase public and private investment in infrastructure. Countries heavily endowed with natural resources can establish and effectively manage national oil funds as seen in Kazakhstan and Azerbaijan. Also, regional initiatives such as the CIS-7 and CAREC can increase the cooperation between governments necessary for large-scale projects. Regional initiative can also increase investment from multinational donors and institutions.

1.16.4 National Oil Funds

In 2000, the President of Kazakhstan established the National Oil Fund of the Republic – a means of growing popularity in the CIS region. In its most basic form, an oil fund amounts to a foreign-currency investment account owned by the state. Oil funds can help to both save funds from oil windfall revenues and act as a stabilization tool to lessen the burden from the price volatility of oil79. Many countries have developed funds to protect against the natural resource curse, the most notable being the Norway Oil Fund, upon which NFRK is modeled.

The Fund is administered by the Ministry of Finance and proceeds from oil royalties, sale of mineral assets and privatization are all placed in the Fund. The assets are held at the National Bank of Kazakhstan and managed according to the Ministry of Finance guidelines. Government oversight is provided by the Management Council formed by the President, the Prime Minister, and members of Parliament, with an annual independent audit80.

In 2003, the Fund had accumulated $2.3 billion. Unfortunately, there was still a lack of transparency with the Fund81. In May 2004, $3.7 billion (equivalent to 10 percent of GDP) had accumulated. Initially, the government identified 12 major companies in the natural resource sector to deposit revenues from the NFRK. By 2004, the number of entities was reduced to 6 and the list was limited to petroleum companies. Flows to the NFRK consist of a savings component equal to 10 percent of the budgeted baseline revenue from the listed natural resource companies ($100 million in 2003), invariant to price changes. The “stabilization” component includes all revenues from listed companies above the baseline price, which has remained fixed at $19/bbl. The use of NFRK resources (for specific projects), in the event of petroleum revenue shortfalls from the budgeted levels established at an assumed $19/bbl, is to be channeled through the budget.82

The establishment of national oil funds as a means of distributing oil revenues is an important step taken by the governments in Azerbaijan and Kazakhstan. The funds aim to provide transparency and accountability in directing excess revenues to directly benefit the citizens through economic diversification and social services. As both Azerbaijan and Kazakshtan increase foreign investment within their borders, the impact

79 Caspian Revenue Watch80 The National Embassy of Kazakhstan81 The Economist. June 12, 200382 Berengaut, Julie “Republic of Kazakhstan: Selected Issues”

38

and importance of these funds will continue to take on greater importance. With its decreasing reserves, Azerbaijan will rely heavily on its national oil fund to properly distribute wealth in an attempt to diversify the economy before its oil production is exhausted.

However, for the national oil funds to utilize their full potential, open and transparent institutions must be established within the country. Accountable, political institutions must prosper not only within the energy-rich CIS countries, but to transport states, such as Georgia and the entire CIS region as well. For oil funds to achieve their aim, transparency, accountability, and checks and balances need to be in place. These characteristics are found most predominantly in democratic societies where the rule of law is determined by, and enforced by, the citizens rather than a single individual. Without the necessary level of accountability, the oil funds run the risk of becoming a political tool at the hands of the powerful, ruling elite.

With its increased orientation to the West, there is increasing optimism that the former Soviet states of the CIS region will become increasingly more democratic and open. With significant investments in the region, the United States and EU must foster strong relationships and continue to assist in promoting democratic institutions and free and fair elections. A stable CIS is of increasing importance to the western world and can best be achieved if the government is representative of the citizen’s needs and wants.

For their part, foreign oil and natural gas companies can best provide corporate social responsibility if they encourage citizens to monitor and observe their governments’ use of resource funds. In the absence of democratic institutions and the rule of law, these companies must provide the terms of their PSAs and the amount they pay the governments for the agreements. In Azerbaijan, the BTC consortium led by BP has already disclosed their production-sharing agreements for the project. It is in the best interest of oil and natural gas companies to ensure long-standing relationships with their host countries and to make certain the oil and gas funds are properly distributed to the citizens. Because the oil and natural gas sectors are capital-intensive rather than labor-intensive, it is also imperative that the capital obtained from these projects is allocated to providing economic development in labor-intensive industries, as well as social development. As mentioned earlier, the Russian oil and gas sector which accounts for 25% of GDP, employs less than 1% of the population.

We do not suggest that in order for corporations to be socially responsible, they must ignore profit-maximization strategies. Rather, we believe that within the CIS region, companies will be best served in the long run by providing the terms of their agreements to the public. This way, governments can be held accountable for the use, or lack thereof, of oil and gas funds. Ultimately, governments as opposed to multinational corporations, are responsible for the economic development of their countries.

1.16.5 Regional Cooperation

Regional cooperation can also go a long way in improving the economic conditions of the CIS countries. The first attempts at regional cooperation began with the initial development of the Commonwealth of Independent States. The CIS was established in December 8th, 1991 with the signing of the Minsk Agreement by Belarus, Ukraine, and the Russian Federation. The formal treaty dissolving the Soviet Union was signed in Almaty, Kazakhstan soon after and included the original CIS states plus the

39

Central Asian states. By December 1993, Georgia and Azerbaijan joined the CIS bringing the total inclusion to 12 nations. The main political institution of the CIS is the Council of the Heads of State, which intends to coordinate the cooperation of the each sovereign states leaders. The CIS also has a secretariat, labeled the Executive Committee, and an Inter-Parliamentary Assembly. The politics of the CIS is divided between nations wary of a large influence from Russia and other nations seeking a close integration83. However, the CIS does provide the framework for the region to work together on large-scale infrastructure projects, for example the Central Asian Power Grid.

Another regional strategy, the CIS-7 Initiative, was launched in 2002 to promote economic growth and poverty reduction through reform efforts including structural reforms in the energy and financial sectors, as well as preserving macroeconomic stability. The Initiative brings together the seven low-income CIS countries with bilateral donors, international financial institutions and the international community. The main object of the initiative is to assist the CIS-7 with the implementation of their poverty reduction strategies

The Central Asia Regional Economic Cooperation (CAREC) which includes Azerbaijan, Kazakhstan, Turkmenistan, and five additional Central Asia countries, focuses on improving the standard of living through regional economic cooperation. The Program concentrates specifically on financing infrastructure projects and is also an alliance of multilateral institutions including the Asian Development Bank (ADB), the European Bank for Reconstruction and Development (EBRD), the International Monetary Fund (IMF), the UNDP and the World Bank. The partnership, which is expected to contribute over $1.5 billion in assistance for transportation, energy and trade in 2006-2007, is an illustration of the importance of regional cooperation and the positive effects from bilateral cooperation.84

Both the CIS-7 Initiative and the CAREC have raised awareness and attracted the attention of multinational donors including the World Bank and the EBRD. Within the energy sector, the World Bank has fostered important discussions on power sector reforms and regulations within the region, while the EBRD has joined with the ADB to provide loan assistance for an Uzbekistan-Turkmenistan Power Transmission Modernization Project.85 Regional cooperation has provided the necessary funds for infrastructure projects and has also comforted foreign investors worried about regional instability.

83 Economic Intelligence Unit: Turkmenistan84 “CAREC Program.” Asian Development Bank (2006)85 Ibid

40

7 Citations

“Azerbaijan: Asian Development Outlook 2005.” Asian Development Bank (2006)< http://www.adb.org/Azerbaijan/>

Bagirov, S., Akhmedov, I., Tsalik, S . “State Oil Fund of the Azerbaijan Republic.” Caspian Oil Windfalls: Who Will Benefit? (2003) Caspian Revenue Watch.

Barnett, S., and R. Ossowski, 2002, “Operational Aspects of Fiscal Policy in Oil-Producing Countries,” IMF Working Paper 02/177 Washington: International Monetary Fund.

Bartsch, U., M. Katz, H. Malothra, and M. Cuc, 2004, “Lifting the Oil Curse, ImprovingPetroleum Revenue Management in Sub-Saharan Africa” Washington: International Monetary Fund.

Berengaut, Julie. “Republic of Kazakhstan: Selected Issues” (Washington: International Monetary Fund) IMF Country Report No. 04/362

Billmeier, Andreas, Jonathan Dunn, Bert van Selm. “In the Pipeline: Georgia’s Oil and Gas Transit Revenues.” IMF Working Paper (November 2004)

Blagov, Sergei. “Russia Walks Thin Line Between Japan and China.” Asia Times. March 1, 2006. <http://www.atimes.com/atimes/Central_Asia/GA05Ag01.html>

British Petroleum. Azerbaijan Sustainability Report (2004)

“BP’s Shah Deniz Gas Marketing Puzzle.” World Gas Intelligence (15 Jun. 2005)Accessed via Factiva <http://global.factiva.com> (4 Apr. 2006)

“CAREC Program.” Asian Development Bank (2006)<http://www.adb.org>

“Caspian Sea Region Analysis Brief.” Energy Information Administration (2005)<http://www.eia.doe.gov/cabs/Caspian/Full.html>

“Caspian Sea Region: Environmental Issues.” Energy Information Administration (Feb. 2003) <http://www.eia.doe.gov/emeu/cabs/caspenv.html>

“Caspian Windfall: Who Will Benefit?” Caspian Revenue Watch, The Open Society Institute. 2003

CIA World Factbook, Kazakhstan. Web citation: <http://www.cia.gov/cia/publications/factbook/geos/kz.html>

41

“Corruption Perceptions Index 2005.” Transparency International (2005)<http://www.transparency.org>

Daly, John C.K. “China and Japan Race for Russian Crude.” Japan Focus. Online. <http://japanfocus.org/article.asp?id=081>

DOE. “Major Russian Oil and Natural Gas Projects.”

Editors. “Japan-Oil.” EIA Country Analysis Briefs. November 2005. <http://www.eia.doe.gov/cabs/Japan/Oil.html>

Editors. “Major Russian Oil and Natural Gas Projects.” EIA Country Analysis Briefs. March 2005. <http://www.eia.doe.gov/emeu/cabs/russia_pipelines.html>

Editors. “NIRA Policy Research.” National Institute for Research Advancement (Japan) 2001. <http://www.nira.go.jp/publ/routp/pdf/v14n01.pdf>

Editors. “Seven Futures.” CSIS. <http://216.12.139.57/southeastasia/index.cfm>

“Geopolitics.” Petroleum Economist (1 Mar. 2006)Accessed via Factiva <http://global.factiva.com> (4 Apr. 2006)

“Georgia fears upcoming agreement could give Gazprom control.” Alexander’s Gas & Oil Connections (10 Jul. 2003)Accessed via Factiva <http://global.factiva.com> (2 Apr. 2006)

Gochitashvili, Dr. Teimuraz. “Energy Resources and Energy Security of Georgia.” (2003)

Hansen, Sander. “Pipeline Politics: The struggle for control of the Eurasian energy resources.” The Clingendael Institute (2003)

Hausmann, R., and R. Rigobon, 2002. “An Alternative Interpretation of the ‘ResourceCurse’: Theory and Policy Implications” NBER Working Paper No. 9424.

“In the pipeline: Georgia’s oil and gas transit revenues.” IMF Survey (1 Aug. 2005)

Ismayilov, Rovshan. “Azerbaijan: An Unlikely Solution to Georgia’s Energy Woes.” Eurasia Net (27 Jan. 2006) <http://www.eurasianet.org/departments/insight/articles/eav012706_pr.shtml> (2 Apr. 2006)

Jun, Jan. “Caspian: Oil reserves will last but export routes urgently needed.” Radio Free Europe (15 Feb. 2006) <http://www.rferl.org>

42

Karagiannis, Emmanuel. “The Turkish-Georgian partnership and the pipeline factor.” Journal of Southern Europe and the Balkans (2004) 6 (1), 13-26

“Kazakhstan Seeks Undersea Pipeline to Reach BTC.” Financial Times (15 Mar. 2006) Accessed via LexisNexis <http://web.lexis-nexis.com> (16 Mar. 2006)

“Kazakhstan: Welding New Relations.” Petroleum Economist (8 Feb. 2006) Accessed via LexisNexis <http://web.lexis-nexis.com> (16 Mar. 2006)

Khristenko, Viktor. “Breakthrough to the East.” G8 Summit 2006. February 6, 2006. <http://www.en.g8russia.ru/news/20060206/1142732.html>

Kober, Stanley. “The Great Game, Round 2: Washington’s Misguided Support for the Baku-Ceyhan Oil Pipeline.” Cato Institute (2000) 63, 1-11.

Lewis, Charles Paul. How the East was Won. The Impact of Multinational Companies on Eastern Europe and the Former Soviet Union . Palgrave MacMillan, NY. 2005

Malecek, Steven J. “Pipeline transit states: How can the legal regime meet investor objectives and internal development needs? The case of Georgia and Caspian exports.” International Law of Natural Resources (Jan. 2001)

Mitra, Predeep; Selowsky Marcelo. “Transition: The First Ten Years. Analysis and Lessons for Eastern Europe and the Former Soviet Union” Washington DC: The World Bank. 2002

“Modern Technologies and Formation of Human Gold.” Azerbaijan National Human Development Report (2003) <http://www.un-az.org/undp/nhdr2003/34.html>

Nourzhanov, Kirill. “Caspian Oil: geopolitical dreams and real issues.” Australian Journal of International Affairs (2006) 60 (1). 59-66

Olcott, Martha Brill. Kazakhstan: Unfulfilled Promise Washington DC: Carnegie Endowment for International Peace, 2002

Phillips, David L. “Stability, Security, and Sovereignty in the Republic of Georgia.” Council on Foreign Relations (15 Jan. 2004)

Rasizade, Alec. “The mythology of munificent Caspian bonanza and its concomitant pipeline geopolitics.” Central Asian Survey (2002) 21(1), 37-54

Rutland, Peter “Pipeline Pirouette in Northeast Asia.” The Jamestown Foundation. July 16, 2004. <http://www.jamestown.org/publications>_

Sachs, Jeffery; Warner, Andrew. “Natural Resource Abundance and Economic Growth”. Center for International Development and Harvard Institute for International Development. Harvard University, Cambridge, MA. November, 1997

43

“Security & Terrorism.” UPI Intelligence Watch (15 Mar. 2006)<http://www.upi.com/SecurityTerrorism/view.php?StoryID=20060315-115328-9314r> (16 Mar. 2006)

Shaffer, Brenda. “A Caspian Alternative to OPEC.” The Wall Street Journal 7 Nov. 2001: A22

Shue, Stephen “The Chinese Perspective on the Daqing Pipeline Project.” The Jamestown Foundation. Online. January 20, 2004. <http://www.jamestown.org/publications_details.php?

volume_id=395&issue_id=2 901&article_id=23475>

Socor, Vladimir. “Georgia Extricating From Gazprom’s Bear Hug.” Eurasia Daily Monitor (23 Mar. 2006)

“South Caucasus Pipeline close to beating the odds.” Gas Matters (23 Dec. 2005)Accessed via Factiva <http://global.factiva.com> (4 Apr. 2006)

“Sustainability Report 2004.” BP Azerbaijan (2004)<http://www.bp.com>

The Economist Intelligence Unit. Azerbaijan Country Profile 2005

The Economist Intelligence Unit. Georgia Country Profile 2005

The Economist Intelligence Unit. Turkey Country Profile 2005

“The South Caucasus Pipeline.” All Business<http://www.allbusiness.com/periodicals/article/178431-1.html> (2 Apr. 2006)

“The South Caucasus Pipeline.” The Turkish Policy Quarterly (2005) 3 (4), 20-23

“The South Caucasus Pipeline.” The Turkish Policy Quarterly (2005) 3 (4), 20-23

The National Embassy of Kazakhstan. Web resource: <http://www.kazakhstanembassy.org.uk/cgi-bin/index/67>

The devil’s excrement. The Economist print edition, May 22nd 2003

Tsereteli, Mamuka. “Caspian Gas: Potential to Activate Europe in the South Caucasus.” Central Asia- Caucasus Institute (25 Aug. 2004)<http://www.cacianalyst.org> (2 Apr. 2006)

Waiting to be rich, mystery of the oil billions. The Economist, print edition. June 12, 2003

44

Wheelan, Charles. Naked Economics; Undressing the Dismal Science. W.W. Norton & Company, Inc. 2002

“With Shah Deniz gas two years off, quest to grow project in motion.” Platts Oilgram News (14 Jun. 2004) Accessed via LexisNexis <http://web.lexis-nexis.com> (4 Apr. 2006)

45